The decline of the US dollar

While the fact that the $A is now worth 60 US cents is newsworthy,this report, like most others, has the analysis the wrong way around. It starts by talking about the Australian economy and only later gets on to the real story, the depreciation of the $US against all major currencies. The same problem arises in discussions about the price of oil, gold etc – much of the price rise we have seen simply reflects the fact that the price is standardly expressed in terms of US dollars.

The US dollar was massively overvalued for most of the 1990s, causing great harm to the traded goods sector, particularly manufacturing. Manufacturing employment fell steadily during the last years of the boom, crashed during the recession and has continued to decline during the subsequent recovery. A striking manifestation of overvaluation is the fact that the US now spends twice as much on manufacturing imports as it earns for manufacturing exports (the disparity is probably greater for Australia, but we’ve never been a significant exporter of manufactures, unlike the US).

As I argue here, a depreciation of the US dollar is both inevitable and desirable. That doesn’t mean it will be painless, though. In particular, it raises the question of why anyone outside the US would want to hold US bonds, particularly with the 10-year bond rate below 4 per cent. Given a likely further depreciation of 15 per cent against the euro, and maybe more, this seems silly.

In part of course, the explanation may be the magical power of a dominant currency, reflected in the fact that for most commentators the $US/$A exchange rate is the exchange rate, even though the US is not our most important trading partner. When and if this spell is broken, long-term interest rates in the US are likely to rise to levels that reflect the underlying economic realities of chronic deficits on all accounts rather than the supposed ‘safe haven’ appeal of a reserve currency.